Letter to James Leach<\/p>\n

January 22, 2002<\/p>\n

The Honorable James A. Leach
\nChairman Emeritus
\nFinancial Services Committee
\nU.S. House of Representatives<\/p>\n

Dear Jim:<\/p>\n

I know that much titillating testimony will be taken about ENRON.\u00a0 There will be testimony about conflicts of interest, timing of disclosure, the role of external auditors, shredding of documents etc.\u00a0 The fact is these are matters which are already covered by existing rules, regulations and laws.\u00a0 I would suggest that the heart of the matter, far more difficult to describe in TV quick bites, newspaper reports, talk shows, or Congressional hearings is the nature of the transactions which caused ENRON to suffer such huge losses and precisely why and how the accounting rules permitted \u201cwriggle room\u201d not to disclose the transactions and their implications.\u00a0 I am convinced that ENRON is just the latest in\u00a0 a long series of scandals.\u00a0 As I have written over the last sixteen years, assuredly there will be other scandals of equal, if not greater magnitude, unless and until the regulatory authorities understand completely and fully the nature of off-balance sheet transactions and their implications.\u00a0 I ask your indulgence and hope that you forgive what may seem a lack of modesty, if I summarize below, yet again, my prior Congressional testimony and commentaries on this matter.<\/p>\n

Sixteen years ago, in 1986, in a speech entitled, \u201cBe on Guard in the Glittery World of Financial Innovations,\u201d I spoke of the implicit dangers of the derivatives markets and their accounting.\u00a0 The theme simply was that existing accounting conventions permit us to cover up the implications of off-balance sheet and leveraged transactions.\u00a0 In the 1990s in a piece entitled, \u201cThe Only Perfect Hedge is in a Japanese Garden,\u201d the article warned against \u201cthe use of accounting conventions\u201d which are \u201cirrelevant to financial risk management,\u201d and discussed the dangers of relying on \u201cthe seduction of accounting conventions.\u201d\u00a0 The article notes:<\/p>\n

\u201cWe, generally, do not mark to market.\u00a0 Many of the products are unmarkable.\u00a0\u00a0 We do some transactions explicitly because our mistakes can be hidden, because accounting conventions do not record them, either because they are ad hoc or there is no market, or worse, they are off balance sheet.\u00a0 There is, typically, little reality testing. . . . And when losses can be ignored, greater risks are taken.\u00a0 I cannot take the time here to describe the latest FASB proposed draft on derivative accounting\u2014they aren\u2019t bad; they are a beginning, but they are deficient\u2014because they will not, yet, put you under the pressure involuntarily of admitting to failure, risk and error.\u201d<\/p><\/blockquote>\n

Unhappily, in a somewhat prophetic vein, the article noted:<\/p>\n

\u201cSometimes, too, there are pressures for the financial operations to make up for, as a profit center, the shortfalls in the main-line business.\u00a0 The responsibility is sometimes initiated voluntarily in an effort to show that the corporate treasurer\/CFO does not merely publish accounting statements and issue commercial paper, but is intimately involved in determining whether or not the company makes a profit and a yet higher return on its equity.\u00a0 For multi-national corporations, the correct timing of a move in the foreign exchange markets can do wonders to offset a fall-off in sales.\u201d<\/p><\/blockquote>\n

Eight years ago, after a series of public scandals involving the derivatives market, I again noted the inadequacy of accounting conventions to record off-balance sheet transactions, before the House of Representatives Committee on Banking, Finance and Urban Affairs on June 24, 1994.\u00a0 (That testimony followed my 1991 testimony in which I argued in favor of an independent study of derivative products and their financing.)\u00a0 I testified in 1994:<\/p>\n

\u201cA lot has already been written and reported about derivatives:\u00a0 a minority staff report from this committee, Congressional hearings, a GAO study, a Group of Thirty report and commentaries by virtually every accounting, banking and securities association.\u00a0 There have been press reports of losses by dealers and corporations, lawsuits, investigations and attention by every relevant regulatory agency.\u00a0 For purposes here, let me try to focus on why the subject matter has and will likely cause a great deal of continuing stress.\u00a0 I believe it is a peculiar\u00a0 combination of five unique and potentially dangerous circumstances.<\/p>\n

 <\/p>\n

First derivatives can be used to leverage risk \u2013 interest rate, currency rate, share prices \u2013 without putting up a lot of money.\u00a0 That simply means that during a period of volatility, losses or gains are magnified manyfold.\u00a0 And often the leverage is asymmetrical; that is, the potential gains are limited, while the losses may be multiples of the maximum gain.<\/p>\n

 <\/p>\n

Second, current accounting conventions mask error, risk and mistake.\u00a0 They are not designed as risk management tools.\u00a0 They have tax consequences, which may be one of the reasons why it has been so difficult to develop a comprehensive set of conventions which also can be used for risk management purposes.<\/p>\n

 <\/p>\n

The truth is we do not, generally, mark derivatives to market\u2026<\/p>\n

 <\/p>\n

Third, senior managers are rarely as informed as traders, and legislation is not likely to make them so.\u00a0 Typically, senior management is usually unaware of the technical operations of financial engineering.\u00a0 Worse, they are often afraid to ask, out of concern of admitting to their lack of mastery over the subject matters, and I think we also must admit to the fact that there is a good deal of underlying hostility to financial superstars, mathematicians, physicists. . . . Management is not trained in the intricacies of convexity or volatility. As a result, reports are inadequate, supervision thin.\u00a0 Risk management leaves a lot to be desired. . . .<\/p>\n

 <\/p>\n

Fourth, many products, particularly over-the-counter derivatives and aspects of the mortgaged-backed market are idiosyncratic, ad hoc, unpublicized, illiquid.\u00a0 That means they are difficult, if not impossible, to price or value.\u00a0 It means that if held as collateral, there may be no buyers in the event of a forced sale, or the spreads between buyers and sellers may be so wide that even hedges are ineffective.<\/p>\n

 <\/p>\n

This brings me to my final point and, to my own mind, the most important.\u00a0 We have enough essays, surveys, studies, green books, Basle guidelines, international studies about credit risk, basis risk, legal risk, event risk, operational risk. They are all fine and so will be future ones — whether mandated by legislation or done voluntarily.\u00a0 But they all read like a cross between graduate school theses, at best, and a public policy consultant\u2019s think-piece.\u00a0 We are writing essays without really knowing, in a systematic fashion, how the market works.\u00a0\u00a0 We need far more precise day-to-day market information on who does what; how is it financed; how do bankers and dealers pass on their risks; how is leverage actually <\/u>accomplished, etc.\u201d<\/p><\/blockquote>\n

Little, if anything, however was done.\u00a0 There were more scandals, more losses (Orange County, Barings, Merrill Lynch, Sumitomo Bank, Long-Term Securities, etc.).\u00a0 Again, I was asked to testify before the House of Representatives Committee on Banking, Finance and Urban Affairs, and I did so again on October 1, 1998.<\/p>\n

And, again, I testified:<\/p>\n

\u201cLittle has changed from that testimony (House, 1994).\u00a0 I can only repeat, yet again, my primary recommendation:\u00a0 An independent study, authorized by and reporting to Congress should address the forgoing matters, conducted with subpoena power.\u00a0 It should not be an essay, survey or boiler-plate descriptions of the \u201cmarket.\u201d\u00a0 The truth is there is very little expertise within the federal regulatory supervisory agencies as to precisely how the financing and leveraging is actually done in practice.\u00a0 That must be determined by a dedicated group with full access to the most sophisticated and active players in the market.\u00a0 Then, after the facts and operational practices and procedures are fully understood, the study can then address some very difficult policy issues, e.g., 1) how to monitor or constrain activities in a global cross border market with different (or non-existent) regulatory structures; 2) how to share information about credit exposures without running afoul of anti-trust, privacy or competitive considerations; and 3) how to monitor and constrain \u201cleverage.\u201d<\/p><\/blockquote>\n

Recently, at an SEC seminar in the Spring of 2001 and again in October 2001, at a symposium honoring the 40th Anniversary of the SEC Special Study, I argued that the single most dangerous, least understood, and poorest disclosed product in the securities markets were derivative transactions.\u00a0 I argued that the scandals and excesses were and are predictable.\u00a0 And they will occur again, particularly if we continue to avoid confronting the fundamental issues of leverage, off-balance sheet transactions and the deficiencies of the accounting for such transactions.\u00a0 While headlines surely will be made of document shredding, far more important from a public policy perspective\u00a0 is exactly what the off-balance sheet debt was used for, how much leverage was involved, who lent the money, what was the collateral for the debt, and, perhaps most important, what were the exact transactions resulting in such huge losses for ENRON.<\/p>\n

Kindest regards,<\/p>\n

Eugene H. Rotberg<\/p>\n

cc:\u00a0 The Honorable Harvey Pitt
\nChairman, Securities and Exchange Commission<\/p>\n","protected":false},"excerpt":{"rendered":"

Letter to James Leach January 22, 2002 The Honorable James A. Leach Chairman Emeritus Financial Services Committee U.S. House of Representatives Dear Jim: I know that much titillating testimony will be taken about ENRON.\u00a0 There will be testimony about conflicts of interest, timing of disclosure, the role of external auditors, shredding of documents etc.\u00a0 The […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_et_pb_use_builder":"","_et_pb_old_content":"","_et_gb_content_width":"","footnotes":""},"categories":[4],"tags":[],"_links":{"self":[{"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/posts\/197"}],"collection":[{"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/comments?post=197"}],"version-history":[{"count":4,"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/posts\/197\/revisions"}],"predecessor-version":[{"id":585,"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/posts\/197\/revisions\/585"}],"wp:attachment":[{"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/media?parent=197"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/categories?post=197"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/generotberg188.com\/wp-json\/wp\/v2\/tags?post=197"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}